Trust Reformed as CRAT to Qualify for Estate Tax Deduction

Trust Reformed as CRAT to Qualify for Estate Tax Deduction

News story posted in Letter Rulings on 8 July 1998| comments
audience: National Publication | last updated: 18 May 2011
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Summary

In private letter ruling 9827010, the IRS rules that an estate will be entitled to a charitable deduction for the present value of the remainder interest in a trust and for the present value of a guaranteed annuity in a trust provided that the non-charitable trust beneficiary validly disclaims his right to receive consumer price index adjustments in the amount of his annuity and provided that a court rules that the trust must be reformed. The IRS held that the portion of the annuity amount going to two charities after the reformation would constitute a guaranteed annuity under Code Section 2055(e)(2)(B) and the related regulations.

SUMMARY:
In private letter ruling 9827010, the IRS rules that an estate will be entitled to a charitable deduction for the present value of the remainder interest in a trust and for the present value of a guaranteed annuity in a trust provided that the non-charitable trust beneficiary validly disclaims his right to receive consumer price index adjustments in the amount of his annuity and provided that a court rules that the trust must be reformed. The IRS held that the portion of the annuity amount going to two charities after the reformation would constitute a guaranteed annuity under Code Section 2055(e)(2)(B) and the related regulations.

FACTS:
Decedent's will provides that the residue of her estate is to be held in trust, with the sum of $52,000 to be paid to a non-charitable beneficiary on an annual basis. This sum is to be adjusted each year in accordance with the consumer price index but is never to be less than $52,000. Any remaining trust income is to be paid in equal quarterly installments to two charities. At the death of the non-charitable beneficiary, the remainder is to pass in equal shares to the two charities.

The estate instituted a judicial proceeding to reform the trust into a charitable remainder annuity trust. The estate proposes to have an annuity of 5 percent paid each year. Of this 5 percent amount, 12.8 percent will go to the non-charitable beneficiary and 87.2 percent will go to the two charities. The remainder of the trust will pass to the two charities at the non-charitable beneficiary's death. The reformation will be effective as of the decedent's death.

The IRS noted that the difference between the actuarial value of the charitable interest prior to the reformation and after the reformation will not exceed 5 percent of the actuarial value of the reformable interest. The non-charitable beneficiary's interest after the reformation will terminate at the same time that it would have terminated if the trust was not reformed.

HOLDING:
The trust will be a charitable remainder annuity trust after the reformation assuming it is a valid trust under local law. The trust will be exempt from income taxes each year that it continues to meet the requirements of Code Section 664 unless it has unrelated business taxable income. The estate will be entitled to a charitable deduction under Code Section 2055 for the present value of the remainder interest in the trust and for the present value of the portion of the annuity to be paid to the charities. The IRS noted that these rulings are expressly contingent upon the issuance of a court order requiring the proposed reformation.

POINTS TO PONDER:
In this ruling, it is not clear why the decedent's will did not include a formal charitable remainder trust. Although reformation is available in certain cases, it is important to keep the rules of Code Section 2055 in mind when drafting estate planning documents.

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Date: March 31, 1998
Refer Reply to: CC:DOM:P&SI:4/PLR-121973-97
In Re: * * *
LEGEND:
Decedent = * * *
Trust = * * *
A = * * *
Charity 1 = * * *
Charity 2 = * * *

Dear * * *

This is in response to a letter dated November 25, 1997, and subsequent correspondence submitted on behalf of Trust by your authorized representative, requesting rulings regarding the reformation of Trust under section 2055(e)(2) of the Internal Revenue Code. Specifically, rulings were requested that:

1. As a result of A's disclaimer of A's right to receive the Consumer Price Index adjustments with respect to his annuity provided under paragraph EIGHTH(A) of Decedent's will, the charitable remainder interest provided under Decedent's will constitutes a "reformable interest" under section 2055(e)(3)(C).

2. The proposed reformation will constitute a "qualified reformation" under section 2055(e)(3)(B).

3. The trust, as reformed, will meet the requirements of a charitable remainder annuity trust under section 664(d)(1).

4. The portion of the annuity amount that is to be paid annually to Charity 1 and Charity 2 will constitute a guaranteed annuity under section 2055(e)(2)(B) and section 20.2055-2(e)(2)(vi).

5. A federal estate tax charitable deduction will be allowed under section 2055(a) based on the present value of the charitable remainder interest and the present value of the charitable guaranteed annuity interest provided for under the trust as reformed.

FACTS:

Decedent died on April 12, 1997, survived by A. Decedent's will provided that Decedent's residuary estate is to be held in a residuary trust (Trust).

Under paragraph EIGHTH(A) of the will, the trustee was to pay to A, in monthly installments for life, the annual sum of $52,000. Paragraph EIGHTH(A) further provides:

Said sum shall be adjusted yearly on the date of my death and on each anniversary date thereafter in accordance with the Consumer Price Index or the most nearly comparable successor Index. The base shall be March, 1994, provided however, said sum shall never be less than Fifty-Two Thousand Dollars ($52,000.00) per year.

Under paragraph EIGHTH(C) the remaining net income of Trust is to be paid, quarterly, in equal amounts, to Charity 1 and Charity 2. Under paragraph NINTH, at A's death, Trust is to terminate, and the trustee is to divide the remaining assets into two equal parts and distribute one part to Charity 1 and one part to Charity 2.

On January 9, 1998, within 9 months of Decedent's death, A executed a written disclaimer, in accordance with applicable state law, disclaiming his right under paragraph EIGHTH(A) to receive adjustments based on the consumer price index with respect to the $52,000 annuity.

As originally drafted, the remainder interest in Trust did not qualify for the federal estate tax charitable deduction. The estate has requested an extension of time to file the federal estate tax return. On March 10, 1998, the estate initiated a judicial proceeding to seek reformation of Trust. The estate requested that Trust be reformed into a charitable remainder annuity trust that is described in section 664(d)(1) (Annuity Trust).

Under the terms of Annuity Trust, as reformed, the trustee will pay an annuity amount equal to 5 percent of the net fair market value, as finally determined for federal estate tax purposes, of the assets passing to Annuity Trust. The annuity amount will be paid for A's life, in equal monthly installments, from income and, to the extent income is not sufficient, from principal. The annuity amount will be paid as follows: to A, 12.8% of the annuity amount; and to Charity 1 and Charity 2, in equal shares, 87.2% of the annuity amount. Any income of Annuity Trust for a taxable year in excess of the annuity amount will be added to principal.

On A's death, Annuity Trust is to terminate and the trustee is to distribute to the estate of A and to Charity 1 and Charity 2 any undistributed annuity amount to which each is entitled. The remaining principal and accumulated income of Annuity Trust is to be distributed in equal shares to Charity 1 and Charity 2.

It is represented that the reformation will be effective as of Decedent's date of death.

LAW AND ANALYSIS:

Section 664(d)(1), prior to amendment by the Taxpayer Relief Act of 1997, provided, in part, that a charitable remainder annuity trust is a trust from which a sum certain (which is not less than 5 percent of the initial net fair market value of all property placed in trust) is to be paid, not less often than annually, to one or more persons at least one of which is not an organization described in section 170(c), and, in the case of individuals, only to an individual living at the creation of the trust, for a term of years not in excess of 20 years, or for the life or lives of the such individuals. Under section 664(d)(1) as amended, the sum certain can be no less than 5 percent and no more than 50 percent of the initial net fair market value of the trust assets, and the actuarial value of the remainder interest must be at least 10% of the initial net fair market value of the property placed in the trust.

Section 2055(a) provides that for purposes of the federal estate tax, the value of the taxable estate shall be determined by deducting from the value of the gross estate the amount of all bequests, legacies, devises or transfers to a person or for the use of any corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, no part of the net earnings of which inures to the benefit of any private stockholder or individual.

Section 2055(e)(2) disallows the estate tax charitable deduction where an interest in property (other than an interest described in section 170(f)(3)(B)) passes or has passed from the decedent to a person, or for a use, described in section 2055(a), and an interest (other than an interest which is extinguished upon the decedent's death) in the same property passes or has passed (for less than an adequate and full consideration in money or money's worth) from the decedent to a person, or for a use, not described in section 2055(a), unless --

(A) in the case of a remainder interest, such interest is in a trust which is a charitable remainder annuity trust or a charitable remainder unitrust (described in section 664) or a pooled income fund (described in section 642(c)(5)), or

(B) in the case of any other interest, such interest is in the form of a guaranteed annuity or is a fixed percentage distributed yearly of the fair market value of the property (to be determined yearly).

The rules contained in section 2055(e)(2) were enacted by the Tax Reform Act of 1969 and are applicable, with exceptions not relevant here, to estates of decedents dying after December 31, 1969. With respect to decedents dying before January 1, 1970, section 20.2055-2(a) of the Estate Tax Regulations provides that if a trust is created or property is transferred for both a charitable and a private purpose, a deduction may be taken for the value of the charitable beneficial interest only insofar as that interest is presently ascertainable, and hence severable from the noncharitable interest.

Section 2055(e)(3) provides for the reformations of charitable interests to comply with the requirements of section 2055(e)(2). Section 2055(e)(3)(A) provides that a deduction shall be allowed under section 2055(a) in respect of any qualified reformation.

Section 2055(e)(3)(B) provides that the term "qualified reformation" means a change of a governing instrument by reformation, amendment, construction, or otherwise which changes a "reformable interest" into a "qualified interest," but only if --

(i) any difference between (I) the actuarial value (determined as of the date of the decedent's death) of the qualified interest, and (II) the actuarial value (as so determined) of the reformable interest, does not exceed five percent of the actuarial value (as so determined) of the reformable interest,

(ii) in the case of (I) a charitable remainder interest, the nonremainder interest (before and after the qualified reformation) terminated at the same time, or (II) any other interest, the reformable interest and the qualified interest are for the same period, and

(iii) such change is effective as of the date of the decedent's death.

Section 2055(e)(3)(C)(i) defines the term "reformable interest" to mean any interest for which a deduction would be allowable under section 2055(a) at the time of the decedent's death but for the rules of section 2055(e)(2).

Under section 2055(e)(3)(C)(ii) the term "reformable interest" does not include any interest unless, before the remainder vests in possession, all payments to persons other than an organization described in section 2055(a) are expressed either in specified dollar amounts or a fixed percentage of the fair market value of the property.

Section 2055(e)(3)(C)(iii)(I) provides, however, that section 2055(e)(3)(C)(ii) shall not apply to any interest if a judicial proceeding is commenced to change such interest into a qualified interest not later than the 90th day after the last date (including extensions) for filing an estate tax return, if an estate tax return is required to be filed.

In the instant case, A made a timely disclaimer under section 2518(b)(2), of his right to the Consumer Price Index adjustments under paragraph EIGHTH(A). The interest A disclaimed is a separate interest in property under section 25.2518-3(a)(1)(i). Further, under state law, A is treated as predeceasing the Decedent with respect to the disclaimed interest. Thus, assuming A's disclaimer otherwise satisfies the requirements of section 2518, the disclaimed interest is treated for estate tax purposes as never having passed to A.

Assuming A's disclaimer was a qualified disclaimer under section 2518, then the charitable remainder interest provided in Trust is a reformable interest within the meaning of section 2055(e)(3)(C)(i), because an estate tax deduction for the value of the interest would have been allowable under section 2055(a), but for the provisions of section 2055(e)(2). A judicial proceeding has been commenced to reform Trust. We conclude that the charitable remainder interest provided under the terms of Trust is a reformable interest under section 2055(e)(3)(C).

The proposed reformation will satisfy the requirements of section 2055(e)(3)(B). The difference between the actuarial value of the qualified interest and the actuarial value of the reformable interest does not exceed 5 percent of the actuarial value of the reformable interest. Both before and after the proposed reformation, A's interest will terminate at A's death. It is represented that the proposed reformation will be effective as of Decedent's date of death. Consequently, provided the court orders the proposed reformation, the proposed reformation will constitute a "qualified reformation" under section 2055(e)(3)(B).

Decedent's will as reformed will contain the provisions set forth in Rev. Rul. 72-395, 1972-2 C.B. 340, as modified by Rev. Rul. 80-123, 1980-1 C.B. 205, and Rev. Rul. 82-128, 1982-2 C.B. 71, and clarified by Rev. Rul. 82-165, 1982-2 C.B. 117. Accordingly, Annuity Trust will meet the requirements of a charitable remainder annuity trust under section 664(d)(1), provided that Annuity Trust will be a valid trust under the applicable local law. Annuity Trust will qualify as a charitable remainder annuity trust, for federal income tax purposes, for any year in which it continues to meet the definition of and functions exclusively as a charitable remainder annuity trust. For such year, the trust will be exempt from taxes imposed by subtitle A of the Code unless it has any unrelated business taxable income as defined in section 512 and the regulations thereunder.

Because Annuity Trust will qualify as a charitable remainder annuity trust described in section 664(d)(1), section 2055(e)(2) will not disallow a federal estate tax charitable deduction for the remainder interest in Annuity Trust under section 2055(a). A federal estate tax charitable deduction will be allowed under section 2055(a) for the present value of the remainder interest passing to Charity 1 and Charity 2 under Annuity Trust, determined in accordance with section 20.2055-2(f)(2)(i).

The 87.2% portion of the annuity amount that is to be paid annually to Charities 1 and 2 will constitute a guaranteed annuity within the meaning of section 2055(e)(2)(B) and section 20.2055- 2(e)(2)(vi). Therefore, an estate tax charitable deduction will be allowed under section 2055(a) for the present value of the annuity payable to Charity 1 and Charity 2, determined in accordance with section 20.2055-2(f)(2)(iv).

The rulings above, other than the ruling that the charitable remainder and income interests under the terms of Trust are "reformable interests," are expressly contingent on the issuance of a court order requiring the proposed reformation.

Except as we have specifically ruled herein, we express no opinion on the federal tax consequences of the transaction under the cited provisions of the Code or under any other provisions of the Code. In particular, we express no opinion regarding the interrelated computation of the estate tax liability.

This ruling letter is directed only to the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

A copy of this ruling should be attached to the federal gift tax return filed with respect to the funding of these trusts.

A copy is enclosed for that purpose.

In accordance with the power of attorney on file, we are sending a copy of this letter to your authorized representative.

Sincerely,
Assistant Chief Counsel
(Passthroughs and Special Industries)
By: George Masnik
Chief, Branch 4

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